- Corporations pay income taxes just like individuals do.
It's reported as the final expense in the income statement.
For example, in 2018, the final three lines
in Exxon Mobil's income statement appeared like this,
with all numbers shown in millions.
The $9.532 billion in income tax expense
reported by Exxon Mobil in 2018
is not necessarily equal to the amount of cash paid
for income taxes during the year.
In fact, Exxon Mobil paid cash of $9.294 billion
for income taxes in 2018.
The difference between reported income tax expense
and the actual amount of cash paid for taxes
arises for two reasons.
First, as with many other expenses,
income taxes are not necessarily paid in cash
in the year in which they are incurred.
Because less cash than this was paid,
there was an increase in the income taxes payable liability
that remained at the end of 2018.
Now in a similar fashion, individuals usually pay
more or less income tax than they actually owe
for a certain year, then the discrepancy is fixed
the following year when they file their tax return
and either pay additional tax or receive a tax refund.
Now the second reason for a difference
between reported income tax expense
and the actual amount of cash paid for taxes
is that income tax expense is based on
reported financial accounting income,
whereas the amount of cash paid for income taxes
is dictated by the applicable government tax law.
The $9.532 billion reported in 2018
reflects the total estimated amount of income tax
expected to eventually be paid based on the income
reported in the current year's income statement.
However, because the income computed using the tax rules
is almost always different from the income
computed using financial accounting standards,
some of this tax may not have to be paid
for several years.
In addition, tax rules may require income tax
to be paid on income before the financial
accounting standards consider that income to be earned.
These differences in tax law income
and financial accounting income
give rise to deferred income tax items.
Consider this example.
Assume that you invest $1,000 by buying shares
in a mutual fund on January 1st.
Also assume that the income tax rate is 40%.
According to the tax law, any economic gain you experience
through an increase in the value of your mutual fund shares
is not taxed until you actually sell your shares.
The rationale behind this tax rule
is that until you sell your shares,
you don't have the cash to pay any tax.
Now assume further that the economy does well
and that the value of your mutual fund shares
increases to $1,600 by December 31st.
Now you should report the $600 gain
in the income statement.
But that gain is not taxed this year
because you haven't sold the shares yet.
If and when you liquidate the shares,
you'll have to pay income tax of $240.
It's the $1,600 value minus the $1,000 cost
times the 40% tax rate.
It would be misleading to report the $600 gain
in your income statement without also reporting
that at some future time, you will have to pay
$240 in income tax on that gain.
This $240 is called the deferred tax liability.
Now note that the deferred tax liability
is not a legal liability, because so far
as the taxing authority is concerned,
you do not currently owe any tax
on the increase in the value of your mutual fund.
However, the deferred tax liability is
an economic liability that should be reported now,
because it reflects an obligation
that will have to be paid in the future
as a result of an event, the increase in the value
of the mutual fund shares, that occurred this year.
Remember, reported income tax expense
in the income statement reflects
the total estimated amount of income tax
expected to eventually be paid based on the income
reported in the current year's income statement.